The bank's job: take your company public, take their cut, and manage the risk in between.
In the context of IPOs, underwriting refers to the process by which investment banks (underwriters) purchase shares from the issuing company at the offer price and resell them to investors, assuming the risk of any unsold shares. In a firm commitment underwriting — the most common structure — the bank guarantees the company will receive the offer proceeds regardless of whether all shares are sold to investors. The underwriter earns a 'gross spread' — typically 3.5–7% of total proceeds — for this service and the associated risks.
Underwriter Gross Spread = (Offer Price − Price Paid to Issuer) ÷ Offer Price × 100%If a company prices at $20/share and the underwriter paid $18.60/share to the company, the gross spread is 7%. On 50 million shares, that's a $70 million fee. The spread compensates the underwriter for: marketing costs (roadshow), risk of unsold inventory, analyst coverage, and ongoing market-making. The spread is split among the lead underwriter, co-managers, and selling group brokers according to a pre-agreed formula.
7% gross spread (standard for smaller IPOs)
The so-called '7% solution' — most US IPOs under $500M price at exactly 7% spread. It's a surprisingly rigid norm given that these are supposedly negotiated. For the company, it's expensive. For the bank, it's a reliable revenue stream with limited downside.
3–4% spread (large-cap or bulge-bracket IPOs)
Larger offerings command lower percentage spreads because absolute dollar fees are still enormous. A $5 billion IPO at 3.5% still generates $175 million in fees. Companies with leverage (strong brand, competitive banker auction) can negotiate spreads down.
Best efforts underwriting
In a 'best efforts' structure, the bank makes no guarantee — it just tries to sell the shares and keeps a commission on whatever it places. If demand is insufficient, the company raises less. This structure is used for riskier or smaller deals where no bank wants to guarantee the full offering. It's a significant red flag about perceived deal quality.
Underwriting fees are one of the largest single costs a company incurs in going public — often exceeding legal fees, accounting fees, and all other IPO costs combined. They're also largely invisible to retail investors because they're baked into the offer price rather than disclosed as a line-item expense. Understanding underwriting explains why direct listings are appealing to companies (no spread), why banks have an incentive to underprice (happy institutional clients receive the pop), and why the 7% norm has persisted for decades despite being economically unjustifiable for large transactions.
Most people assume underwriters are taking on enormous risk to justify their fees. In practice, firm commitment underwriting risk is heavily managed: the roadshow builds the order book before the bank commits, the greenshoe creates a hedge, and the lock-up period prevents insider supply from hitting the market. The real service being sold is access — the bank's relationships with the institutional investors who will anchor the deal. The 'risk' is mostly theoretical.
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